Analyzing the Numbers
The authors applied value-weighted scores using firm-level holdings to assess the level of corporate social responsibility (CSR) of a fund. This allowed them to compare fund performance based on the CSR criterion. To rate individual companies, they employed a KLD database. KLD Research & Analytics is a leading authority on social research for institutional investors, offering research, benchmarks, compliance and consulting services analogous to those provided by financial research service firms.
Their study covered the period from 2003 through 2011 and 2,168 U.S. equity mutual funds. To measure risk-adjusted returns, the authors used the four factors of market beta, size, value and momentum. The following is a summary of their findings:
- High-CSR funds attract larger flows.
- High-CSR funds tend to hold fewer stocks; they are less diversified.
- There is strong evidence that an increase in the level of CSR comes at the expense of a reduction in performance. Said another way, the CSR level of the portfolio is negatively related to its risk-adjusted performance. This result stands controlled for common fund characteristics such as volatility, flows, the size of the assets under management, the number of stocks, the expense ratio and turnover.
- The alpha, or the annualized risk-adjusted return (net of fees), of low-CSR funds was -0.8%, while the alpha of high-CSR funds was -1.5%. The difference, 0.7%, was highly statistically significant (t-stat of 5.8). The difference could not be explained by the expense ratios because they were virtually identical (1.24% for low-CSR funds and 1.21% for high-CSR funds).
- The CSR level negatively predicts the next year’s fund performance.
- There is no evidence of persistence in performance beyond a horizon of one year. Funds with a high CSR score exhibit weaker persistence or higher reversal in their performance.
- Evidence in the literature on mutual funds has shown that investor flows respond positively and significantly to past performance. However, this relationship weakens as the level of CSR increases. Investors in funds with higher ethical standards become less responsive to past performance and derive their utility from non-financial attributes. As the level of ethical compliance increases, it becomes more difficult for investors to find similar investment alternatives and therefore they may be more reluctant to switch to other funds, even when these funds register poor performance.
The findings mentioned above are also consistent with those from Harrison Hong and Marcin Kacperczyk, authors of the study, The Price of Sin: The Effects of Social Norms on Markets, which appeared in the July 2009 issue of the Journal of Financial Economics.
They found that for the period from 1965 through 2006, a portfolio long sin stocks and short their comparables had a return of 0.29% per month after adjusting for a four-factor model comprised of the three Fama-French factors (beta, size and value) and the momentum factor. The statistics were economically significant. In addition, as out-of-sample support, they found that sin stocks in seven large European markets and Canada outperformed similar stocks by about 2.5% a year.
The Bottom Line
While many investors will vote “conscience” over “pocketbook,” there is an alternative to socially responsible investing at least worth considering: avoid socially responsible funds and donate the higher expected returns to the charities that you are most passionate about. In that way you can directly impact the causes you care deeply about and get a tax deduction at the same time.
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